The tax treatment depends on what kind of annuity you own and how you funded it

When you take money out of an annuity, the IRS taxes different parts of your withdrawal at different rates. The portion that comes from your own contributions — the money you put in — is not taxed again. The portion that comes from investment gains and interest is taxed as ordinary income. If you withdraw money before age 59½, you may also owe a 10 percent early withdrawal penalty on the earnings portion, though some annuities and situations have exceptions.

The exact tax bill depends on three things: whether your annuity is may have access to (held in a retirement account like an IRA or 401(k)) or non-may have access to (held in a regular brokerage account), how much of your withdrawal is your own money versus earnings, and whether you are taking a lump sum or regular payments over time.

Key Takeaways

  • Your contributions to a non-may have access to annuity come out tax-free first; only the earnings portion is taxed as ordinary income.
  • may have access to annuities held in IRAs or 401(k)s are taxed entirely as ordinary income because your contributions were made with pre-tax dollars.
  • Withdrawals before age 59½ from the earnings portion trigger a 10 percent IRS penalty in addition to income tax, with limited exceptions.
  • The IRS uses the exclusion ratio method to determine what portion of each payment is your contribution (tax-free) and what portion is earnings (taxable).

How non-may have access to annuities are taxed

A non-may have access to annuity is one you bought with after-tax money outside a retirement account. When you withdraw from it, the IRS lets you recover your own contributions first without paying tax on them again. The earnings — interest, dividends, and investment gains — are taxed as ordinary income at your regular tax rate.

The IRS uses a formula called the exclusion ratio to figure out what portion of each payment is your contribution and what portion is earnings. You calculate it by dividing your total contributions by the expected value of all payments you will receive over your lifetime. If your exclusion ratio is 60 percent, then 60 percent of every payment is tax-free and 40 percent is taxable.

Example: You put $100,000 into a non-may have access to annuity. The insurance company estimates you will receive $250,000 total over your lifetime. Your exclusion ratio is $100,000 ÷ $250,000 = 40 percent. If you receive a $10,000 payment, $4,000 is tax-free and $6,000 is taxable income.

How may have access to annuities are taxed

A may have access to annuity is held inside a retirement account — an IRA, 401(k), 403(b), or similar plan. Because you funded it with pre-tax dollars (or deducted your contributions), the entire withdrawal is taxed as ordinary income. There is no exclusion ratio and no tax-free portion of your payments.

This applies whether you take a lump sum or receive payments over time. The full amount is subject to income tax at your ordinary rate. If you are in the 22 percent tax bracket, a $10,000 withdrawal costs you $2,200 in federal income tax, plus any state income tax owed.

The 10 percent early withdrawal penalty and its exceptions

If you withdraw money from an annuity before you turn 59½, the IRS charges a 10 percent penalty on the earnings portion only — not on your contributions. This penalty is separate from income tax and applies to both may have access to and non-may have access to annuities.

Some withdrawals are exempt from the penalty. Common exceptions include withdrawals due to disability, withdrawals made after you turn 59½, withdrawals that are part of a series of substantially equal periodic payments (called a 72(t) distribution), and withdrawals from a may have access to annuity held in an IRA if you meet the IRA exception rules. Non-may have access to annuities have their own set of exceptions, which vary by insurance company and contract terms.

If you are under 59½ and considering an early withdrawal, check your annuity contract and speak with a tax professional about whether an exception applies to you. The penalty can add hundreds or thousands of dollars to your tax bill.

Lump-sum withdrawals versus annuity payments

The tax treatment is the same whether you take all your money at once or receive it in monthly or annual payments — but the timing of the tax bill is different. With a lump sum, you owe all the tax in the year you withdraw. With regular payments, you spread the taxable portion across multiple years, which may keep you in a lower tax bracket.

If you take a $100,000 lump sum from a non-may have access to annuity with a 40 percent exclusion ratio, you owe tax on $60,000 in that year. If you take $10,000 per year for ten years instead, you owe tax on $6,000 each year. The total tax is the same, but spreading it out may result in a lower rate.

Inherited annuities and spousal rollovers

If you inherit an annuity from someone else, the tax rules change. A spouse who inherits an annuity can roll it into their own IRA or treat it as their own, which defers taxation. Non-spouse beneficiaries must withdraw the entire balance within ten years under current rules, and each withdrawal is taxed according to the same rules that applied to the original owner.

The cost basis — the amount the original owner contributed — does not transfer to you. You pay tax on the full value of each withdrawal, minus only the portion that represents the original owner's contributions if it was a non-may have access to annuity.

Reporting annuity distributions on your tax return

Your insurance company will send you a Form 1099-R each year showing the total amount you withdrew. The form also shows how much is taxable and how much is non-taxable, though you should verify this against your own records and exclusion ratio calculation.

You report the taxable portion on your Form 1040 as ordinary income. If you owe the 10 percent early withdrawal penalty, you report that separately on Form 5329. If you are not sure whether your withdrawal qualifies for an exception to the penalty, file the form anyway and claim the exception; the IRS will adjust your return if you are wrong.

Frequently Asked Questions

Do I have to pay taxes on annuity distributions every year?

Yes, if you are receiving regular payments. Each payment includes a taxable portion (the earnings) and a non-taxable portion (your contributions), and you owe income tax on the taxable portion in the year you receive it. The insurance company reports this on your Form 1099-R.

What happens if I withdraw money from my annuity at age 62?

You will owe income tax on the earnings portion, but you will not owe the 10 percent early withdrawal penalty because you are over 59½. If it is a non-may have access to annuity, your contributions come out tax-free. If it is a may have access to annuity, the entire withdrawal is taxed as ordinary income.

Can I avoid the 10 percent penalty by taking substantially equal payments?

Yes, if you set up a series of substantially equal periodic payments under IRS Rule 72(t), you can withdraw from an annuity before 59½ without the penalty. However, you must follow the rules exactly — the payments must continue for five years or until you turn 59½, whichever is longer, or the IRS will retroactively explore the penalty to all prior withdrawals.

Is the tax on annuity distributions different from the tax on other income?

No, annuity distributions are taxed as ordinary income at your regular tax rate, the same as wages or interest. They are not taxed as capital gains or may have access to dividends, even if the annuity earned money through stock investments.

What if I made after-tax contributions to a may have access to annuity?

Some may have access to plans allow after-tax contributions. In that case, you can use the exclusion ratio to determine the tax-free portion of your withdrawal, similar to a non-may have access to annuity. You will need documentation of your after-tax contributions to calculate this correctly.